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Four Quiet Bargains

Forget what you learned in school about efficient markets. You can’t base stock price expectations solely on estimates of value.

Nobel laureate Robert Shiller argues that you need to account for the impact of investors who are susceptible to headlines and fads. Measuring the impact of these “noise” traders can help you make money.

Noise is every bit as much a part of equilibrium stock pricing as value is. In other words, P = V + N (price equals value plus noise). Ideally I want low-noise stocks with a catalyst that may cause noise to rise and boost the stock price. As a proxy for noise, I divide market capitalization into two components, value and noise. For value I use aftertax operating profit divided by an estimated cost of equity. What’s left is noise, reflecting growth expectations, stories, dreams, predictions and sentiment.

Consider AppleApple. Trailing 12-month aftertax operating profit was $36.2 billion. If we assume cost of equity is 8%, then the stock’s immediate here-and-now value would be $452.5 billion ($36.2 billion divided by 8%), which accounts for 92% of its $491 billion market capitalization. That leaves only 8% to be explained by noise. GoogleGoogle and Amazon.comAmazon.com are far different; noise at these firms accounts for 63% and 98%, respectively, of market capitalization.

Using a conservative estimate for value that excluded all growth expectations, I conducted a ten-year back-test of a low-noise strategy. I targeted potential stocks in the Russell 2000 small-cap universe and identified nonfinancial stocks for which noise accounted for 25% or less of market cap.

I selected the top ten based on one-week change in consensus EPS estimate a potential catalyst for higher noise—and rebalanced monthly. My low-noise stocks averaged a 16.3% annual return, versus 8.9% for the Russell 2000. Here are four quiet bargains to consider:

The noise component for restaurant chain operator Brinker International (EAT, 47) is near zero. But that should change, given the makeovers going on at Chili’s and Maggiano’s. Brinker is more debt-heavy than most restaurants, but that’s because it’s been using its considerable cash flow to repurchase stock. If it switches to debt reduction, it’ll probably be “Look out above!” for EPS.

Actuant (ATU, 37) (noise level: 18%) produces industrial products such as pipeline connectors and moorings for energy drilling platforms as well as hydraulic tools and lift products. It’s the definitive infrastructure play for a growing economy.

Noise? The silence around chemical producer Olin (OLN, 29) is deafening. Its noise stands at -31%, meaning the stock trades for less than the value of its here-and-now operating profit. Olin is a leading producer of chlorine used for vinyls and water treatment, and of caustic soda, used in detergents and soaps. The strongest part of the company is its Winchester-branded ammunition, where demand for bullets is soaring. Sooner or later bullish decibels should rise as Wall Street takes notice of Olin’s cash flow generation, which is already supporting acquisitions. Olin also has a 2.8% dividend yield.

I usually refresh my models and change my portfolios on a monthly basis, so I cringe when I see my recommendations tracked annually, as FORBES does for its columnists. But last year turned out fine, powered by an especially strong gain from Navios Maritime Holdings. Overall my picks were up 33.5% in 2013 compared with 17.5% for similarly timed investments in the S&P 500.

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